Bond investors’ pre-budget optimism in India

Ten-year Indian bond yields have fallen 30 basis points this year alone and many forecast the gains will extend further. It all depends on two things though — the Feb 28 budget of which great things are expected, and second, the March 19 central bank meeting. The latter potentially could see the RBI, arguably the world’s most hawkish central bank, finally turn dovish.

Barclays is advising clients to bid for quotas to buy Indian government and corporate bonds at this Wednesday’s foreigners’ quota auction (India’s securities exchange, SEBI, will auction around $12.3 billion in quotas for foreign investors to buy bonds). Analysts at the bank noted that this would be the last auction before the central bank meeting at which a quarter point rate cut is expected. Moreover the Reserve Bank of India will signal more to come, Barclays says, predicting 75 bps in total starting March.

That is likely to be driven first by recent data — inflation in January was at a three-year low while growth has slowed to a decade low. Barclays notes:

Based on our economists’ view of a 25bp repo rate cut in Q1, and a further 50bp in Q2, we expect the bond curve to fall around 55bpin a parallel move. As such, we recommend extending duration to long end bonds….Given high carry, attractive price returns and our forecast for modest nominal appreciation of the rupee, we expect an approximately10% dollar return (FX unhedged), and a 7% return (FX hedged) on 30-year bonds in the next six months.

But what could eventually determine the extent of policy easing is the upcoming 2013-2014 budget.

Finance Minister Palaniappan Chidambaram has pledged an austere budget to keep an already massive fiscal deficit from ballooning further, and indications are he will keep his promise. Sources have told Reuters of plans to slice 10 percent from the public spending target (after already cutting expenditure by 9 percent in the current fiscal year). while defense spending is also expected to be slashed. Net borrowing in the coming fiscal year will be limited to 5 trillion rupees ($93 billion), investors hope. Such austerity may exacerbate the slowdown but if they allow the RBI to cut rates, borrowing costs for companies will fall.

On the other hand, should the budget fall short of expectations, a huge bond selloff could ensue, leaving the RBI to support the market via bond purchases. Still, investors appear prepared to give the government the benefit of doubt — India’s 10 year yield is just off a near three-year low and the mood is optimistic — always a rare sentiment ahead of an Indian budget.